had been told at a budget meeting that Penn Central "could not hope to get away with" charging extra people against the account because it would be closely audited, and that he had tried to insist that all that Peat, Marwick and the ICC could do (if they learned of it) was to criticize the company, which did not bother him. Bevan was sufficiently concerned about the implications of this and other similar suggestions that in spite of the fact he no longer had accounting responsibility he discussed the matter with Edward Hanley, one of Penn Central's directors, in the summer of 1968. Hanley then met with Walter Hanson, senior partner of Peat, Marwick, in New York. Hanson assured him the account would be watched closely.

When the substance of Bevan's diary entry of April 22 was presented to Hill and to Cole they objected to the use of the term "get away with" but recalled that Saunders had on occasion made comments of similar import. Hill recounted that over the postmerger period, as earnings worsened, Saunders increasingly focused attention on what Hill described as an "expanded use concept" of the merger reserve, indicating a feeling that "in a general sense, the merger reserve ought to be a means of sheltering any unusual costs growing out of the merger." Hill further indicated that Saunders apparently looked upon the reserve as simply a bookkeeping device, and "at one time or another would have solicited a charge to the fullest extent of the reserve provision without regard to the nature of the agreement [with the ICC]." Saunders was clearly attempting to return to his original concept which he had been told could not generate ICC approval. In addition, Hill also stated that Saunders was constantly concerned that maximum use was not being made of the merger reserve and that he "was insistent in his own mind that we were not charging_adequately to the reserve" so that Hill was constantly having to check the reserve to make sure that some legitimate cost was not getting by.

Hill claims that no charges except those permitted under the conditions established by the ICC were made against the merger reserve, to the best knowledge of the accounting department. However, there were two situations where Penn Central returned to the ICC for expansion of authority. In one of these instances again, Saunders was directly involved, seeking to make his influence felt to obtain desired goals. This case involved a group of mail and baggage handlers and a $4.7 million charge. Initial indications were that both Peat, Marwick and the ICC staff were opposed to permitting this charge against the reserve. After meeting with Saunders, Hanson (of Peat, Marwick) apparently changed his mind, agreeing to abide by the ICC decision. And again Penn Central went directly to the ICC chairman. Hill. who had taken over from Cook as comptroller, and Tucker, who had left his position as chairman of the ICC to become a Penn Central vice president, met with Mrs. Virginia Mae Brown, the then current chairman. Once again, Penn Central succeeded in obtaining the

decision it wanted at the Commission level.45 However, the SEC staff believes that $4.7 million charge did not come within the original "merger reserve" criteria and should have been reflected as a period expense during the year ended December 31, 1968. (See further discussion at page 67.)

OTHER DEVICES TO INCREASE RAILROAD EARNINGS

Management's attempts to improve railway earnings through exhortation were described previously, as was the unfortunate practice of skimping on maintenance to save current expenses (and cash). The suggestions for increasing revenues through use of the suspense account and for reducing expenses through delays in the booking of per diem charges, inventory losses, increases in reserves for damages, personal injuries and the like, has been noted, as has the plan to charge current costs against a reserve instead of against current operations. All of these actions were directed toward increasing reported earnings.

The last section was devoted principally to those situations where the accounting department was under pressure to do things which it was resisting. However, it agreed to and sometimes initiated schemes involved in other parts of the earnings management program.

Under railroad accounting, certain facilities are not depreciated but their costs (less scrap value) are charged to ordinary income when abandoned. It was up to Saunders to determine when a facility was considered abandoned, which gave him effective discretion to control expenses of this nature. He took advantage of this situation. In September 1969 Saunders issued instructions that, while he had approved the preliminary forms necessary for retirement of certain properties, none were to be made effective "until accounting authority s received which will avoid these losses from being charged to ordinary operations." Plans were underway for a Master Abandonment Program whereby at some point in the future, ICC authority would be sought to establish a reserve against which both past and future write offs could be made. In the meantime, the abandonments would pile up. 46

Another example of Saunders' keen interest in keeping every somewhat unusual expense item out of the calculation of ordinary income and his willingness to take steps personally to bring it about is a 1964 situation involving certain damage to equipment caused by heavy snowstorms that winter. Saunders wanted to charge it directly to retained earnings. He put a great deal of pressure on the accounting department, and when they resisted, he insisted that they take the matter to the ICC for approval. The Bureau of Accounts turned them down. Saunders then met with Walter Hanson of Peat, Marwick to seek his support, but Hanson, after some research, indicated that he was unable to do so. Saunders wrote back to Hanson stating his basic position:

"I am convinced that the business community benefits from financial reporting practices which are consistent in principle and which meet broad tests of acceptability. At the same time, it is highly important that investors and financial people obtain a correct picture of the effectiveness of management in conducting corporate affairs. It seems to me that the short-term disturbance to earnings produced by such events as the January snowstorm leads to misjudgment in evaluating our direction. The accounting profession and the business world would do well to look to a better solution to the problem of reporting period income." This statement reflects the clearly "even keel" attitude.

A few months later, Saunders was still complaining about the situation asking Bevan "What are we doing to get the Commission to adopt a more realistic attitude in this regard?" Bevan in a reply memorandum stated:

"Practically every well-known accounting firm in the country is strongly in favor of putting, with very few exceptions, all charges through the current Income Account. We believe that as time goes on their influence in this respect on the ICC's position will be such that it will become increasingly difficult to get permission to charge various items to Retained Income. Furthermore, each year a greater percentage of the railroads of the country are having their books audited by C.P.A. 's who, in turn, will insist on this approach with the various railroads involved. Under the circumstances those roads that wish to handle numerous items through Retained Income are going to find themselves very much in the minority and very much in an almost untenable position.

"These are the facts of life as we see the situation at the present time."

Cook testified that the PRR did obtain permission to charge these storm-related costs over the full 1964 year and that it was his impression that this was because of Saunders' intervention, but this matter is unclear.

"One witness testified that from his trips around the system shortly after merger, it appeared that PRR had a lot of unused track, which it was apparently not taking out of service because it did not want to incur the service costs.

Also in 1969 Penn Central established a reserve for "Loss on Investment in Long-Haul Passenger Facilities" of $126 million. The ICC disallowed the item for ICC reporting purposes, but the company included it in its reports to the public. The basis for ICC disapproval was that the properties were still in use and had not been abandoned. The company, on the other hand, claimed that there was a permanent impairment in value and wrote it off anyway." This had the earnings advantage of lowering depreciation costs now and in future years (most of this property was depreciable). And the reserve, labeled as an extraordinary item in the 1969 income statement, would be construed as such by the investment community, and thus its effect on reported income in 1969 would be discounted.

In this last situation, perhaps more disturbing than the transaction itself is the inconsistency with the prior item. Here, property still in use was nonetheless written off in order to save on current expenses, whereas in the last instance, property which was effectively abandoned was not written off, again to save on current expenses. The influence of the maximization policy is clear.

49

In 1969 Penn Central had another problem. It had been forced to absorb the New Haven Railroad. The New Haven had lost $22 million in 1968 and had a consistent pattern of unprofitable operations, which Penn Central could ill afford to report considering its own disastrous performance. Saunders suggested a reserve for operating losses be established, but was told that this was clearly impossible under generally accepted accounting principles. However, a treatment was found that reduced the earnings impact, at least over the short term. The state of New Haven's equipment was very poor, it was claimed, and it had to be rehabilitated. On this basis, a very high proportion of the total maintenance cost attributable to the road in 1969 was written off against a liability for rehabilitation cost 50 established as sort of negative goodwill in connection with the purchase of the New Haven properties.51 As a result total maintenance costs in 1969 were very significantly lower than they had been in the prior year. Peat, Marwick, after initial objection to Penn Central's claim, finally relented and accepted the company's position. On the other hand, for purposes of reporting to the ICC, the company was forced to treat $22 million of these charges as ordinary maintenance, not rehabilitation, and charge them against ordinary income. The result was a $22 million difference in the profit figures reported to the ICC and to the public in 1969.

47 The files of Peat, Marwick, discussing 1969 accounting problems, carry the following notation concerning this item:

"Two conflicting theories of accounting may be advanced with respect to the long-haul passenger service situation. On the one hand, there is ample precedent for writing down assets to their net realizable value; on the other hand, an argument can be made that to continue long-haul passenger service carries with it the obligation that the true costs of providing that service is rendered. We can see merits to both arguments, and, therefore believe we must respect Penn Central's position."

48 The financial statements did carry a footnote reporting the difference between the treatment in the shareholder report and the ICC report, and the fact that the item had a $4.5 million impact on depreciation in 1969.

49 Hill testified that on the structuring of the New Haven transaction "I know I did a lot of head-scratching, trying to figure out a means to achieve the objectives that seem evident in Interstate Commerce Com mission with the least possible burden on the Transportation Co."

Cole's budget meeting minutes indicate that at one meeting the suggestion was thrown out that the New Haven be assigned to the employees' pension fund! While this was not ultimately done, the idea wa that the equity could be given away, while Penn Central continued to operate the road. This way it would not have to be included in Penn Central's results.

50 It was contemplated that when the $40 million sum thus reserved was exhausted further such expense might then be capitalized.

51 When Peun Central's comptroller was asked if anyone in Penn Central ever expressed the opinion that this was nothing more than a reserve for future losses he replied that "there was a great deal of cynicism among people that did not understand the accounting principle involved."

Another consistently unprofitable railroad property was Lehigh Valley Railroad Co., a 97.3-percent owned subsidiary of Penn Central. Losses in 1968 and 1969 were $5-$6 million per year. However, despite the very high percentage of ownership, Lehigh Valley's results were not included in the consolidated statements, thereby permitting the parent to report a higher net income. The justification claimed was a fiction that the Lehigh Valley was being held only on a temporary basis.52

NONRAILROAD OPERATIONS

The emphasis thus far has been on railroad activities. However, in the quest for income to meet management's earnings goals, nonrailway areas, particularly those related to real estate and investment activities, presented even greater opportunities.

The Penn Central complex includes over 170 separate companies.53 The key entity is Penn Central Transportation Co. which has direct responsibility for operating the railroad, and also holds securities in various railroad and nonrailroad subsidiaries. The bulk of the nonrailroad assets are held through the Pennsylvania Co. (Pennco), a 100-percent owned subsidiary of the Transportation Co., which functions principally as a holding company for the various investments it controls. Both Pennco and the Transportation Co., have numerous subsidiaries involved in railroading, real estate, and other endeavors. Above the Transportation Co. on the organization chart is Penn Central Co., a parent holding company formed on October 1, 1969.54 This company is basically a shell with virtually its sole asset being 100-percent of the stock of the Transportation Co. In requesting shareholder approval of this change in organization management told the shareholders that the holding company device was being adopted to simplify the diversification process and to reflect the importance of nonrailroad operations, getting away from the image of Penn Central as a railroad company. Basically, what was occurring was that the railroad's record was so dismal and its future so unappealing that the company wanted the public to forget it was a railroad. However, as indicated earlier, the dominant feature in the earnings picture of the Penn Central system was the very substantial losses being generated by the railroad system.

In assessing the impact of nonrail activities on Penn Central's income statements, two sets of figures should be considered. One consists of consolidated figures, those of Penn Central and its majority owned subsidiaries. The other represents figures of the principal operating entity 55 on an unconsolidated basis, hereinafter referred to as "company-only" or "Transportation Co."

The impact of the drain from railroad activities and the importance of nonrailway activities to the Penn Central organization is shown by the following table:

"See further discussion on page 64.

A simplified chart, showing the major companies relevant to the discussions in this report, is included as exhibit IB-2.

Up until this date what is now the Transportation Co. was the top entity and carried the name Penn Central Co.

"The Transportation Co. and its predecessors.

Some of the income from nonrailway operations 56 represented the results of routine activities but other portions clearly reflect the results of the maximization policy and Saunders' desire to conceal the earnings slide.

In the company-only statements, substantial income was derived from rental properties, principally New York real estate formerly held by the New York Central, from dividends and interest received from consolidated subsidiaries, from dividends and interest on other investments, from gains on sales of property and from tax allocation agreements negotiated with subsidiaries who benefited tax-wise from the railroad's losses. Because Penn Central had the power to control the timing of gains on sales of investments and properties, and dividends from controlled companies, these categories offered particularly attractive opportunities for programing reported earnings.

In the consolidated statements the major categories of nonrail income, without elimination of minority interest and without deduction of interest expense, were as follows:

Source: Assembled from information in 1970 Pennco offering circular.

In the mid-1960's PRR, knowing that it was going to be required by the ICC to dispose of its very substantial interests in the securities of the N & W and the Wabash Railroad, and dissatisfied with the results of its own railroad operations, embarked on a major diversification program. Pursuant to this program by 1965 it had acquired, through Pennco, controlling interests in Buckeye Pipeline Corp. and in three real estate development companies, Great Southwest Corp.,

56 Certain railway-related activities of companies other than the Transportation Co. are included in the nonrailway figures.